I’m Not Trying To Scare You. I’m Trying To Help You.

I’ve been accused lately of being a perma-bear, of trying to scare people and of being downright gloomy. It is not my intention to scare people. I’ve been consistently striving to inform people so they can be adequately prepared for what is the simple mathematical reality of the markets going forward.

By now, I’m used to these sorts of responses. People looked at me funny and called me names back in summer 2005 when I started warning about the real estate market. They did so again, in March of 2009 when I told people that the “opportunity of a lifetime” was staring them in the face.

And it’s not just me trying to share the bleak message of the markets today. Nobel prize-winner, Robert Shiller, has written as much in the latest edition of his seminal book Irrational Exuberance. Jeremy Grantham, Ray Dalio and others have also recently  informed us of their depressing forecasts for both stocks and bonds over the coming decade.

The reason I seem so bearish today is that I feel the current risk/reward equation in the stock market presents investors with all risk no reward. Valuations, across a variety of metrics, suggest stocks are roughly 80% above their long-term average.

valuation-indicators-arithmeticChart via Doug Short

This means the best possible return from stocks is roughly, 3.5% per year, in line with long-term earnings growth as valuations and profit margins remain at elevated levels for the foreseeable future. The worst case scenario sees stocks falling roughly 40% by 2025 as valuations contract to historically low levels. Before you dismiss the latter possibility you should know that the San Francisco Fed sees it as a real possibility.

In fact, owning equities today, even as a passive investor, can’t even be called “investing.” In The Intelligent Investor, Ben Graham defined it this way:

An investment operation is one in which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

With valuations so high and potential downside so great, you simply can’t argue that there is any “safety of principal” in stocks today. In addition, the most valuable measures, including Warren Buffett’s favorite, suggest returns from stocks going forward will be roughly 0% in real terms so they provide inadequate return.

Ultimately, owning stocks today is speculating the market will do well in spite of the overwhelming evidence to the contrary. If you want to play that game, of course that’s your prerogative. But you should do it with your eyes wide open and knowing the truth, not by deluding yourself into believing you’re investing or some similar sort of notion. And that’s all I’m trying to do, inform you of these realities.